Prime Minister Boris Johnson recently announced an increase in the rate of National Insurance contributions that employers and employees will pay on earnings. Both rates will increase by 1.25 per cent from 6 April 2022, with the 1.25 per cent charge becoming a separate Health and Social Care Levy from 6 April 2023. We have been looking at the impact on business owners who may be looking towards an exit, or who have already sold up and are waiting for an earn out payment.
Clearly, the rise in employer NICs will increase the cost of employing staff. If this cost is not passed on in full to customers, the impact will be a downward pressure on a company’s future profits, measured as earnings before interest, tax, depreciation and amortisation (EBITDA). Buyers will therefore factor in this additional cost when preparing forecast adjusted EBITDA in their pricing considerations. Sellers will need to factor this into the quantification of employment costs in information memorandum financial data.
Earn out arrangements
Where an earn-out payment for a sale which has already taken place is calculated on future EBITDA, the earn out profit targets may be harder to achieve after the impact of the additional NICs cost. Ideally discussions as to how to maintain EBITDA and achieve earn out targets should take place ahead of the new rates kicking in.
In terms of quantum, the cost to a company, and therefore the potential impact on its EBITDA, will broadly be £125k for every £10m of gross salary cost (assuming all employees earn a sufficient sum to exceed the earnings threshold). This may not sound a huge amount, but for labour intensive industries this could result in significant price differentials. For example, for a business with a gross salary bill of £10m and a transaction price based on a multiple of historic EBITDA of 10, the reduction in price could be as high as £1.25m if the NICS effect is not mitigated.
Equity reward plans
Equity reward plans often crystallise on an exit event and retaining key management through a transaction, and particularly an earn out period, is often critical to a successful exit. Whilst tax advantaged plans such as Enterprise Management Incentives (EMI) will generally not suffer a NICs charge when options are exercised on a transaction, the increased rate could be a significant additional cost of operating unapproved equity reward plans unless the employees concerned have entered into an election to bear the cost of the employer’s NICs. On the flip side, employees may not be too impressed to be footing the bill for the entire 2.5 per cent increase in NICs (although they would benefit from income tax relief for the employer’s NICs).
An interesting consideration in this regard is whether joint elections that employers and employees have entered into under equity reward plans to date to transfer the cost of employer’s NICs to relevant employees, will be extended to also apply to the 1.25 per cent Health and Social Care Levy once it is carved out from NICs as a separate levy/tax.
The elections specifically relate to employer’s NICs, but the wording of the legislation appears to extend the application of both existing and new elections to the new levy. We would expect this issue to be a key consideration in due diligence exercises, to make sure buyers/investors are not caught out with an unexpected cash cost shortly after completion that is not provided for in the pricing mechanics. Sellers, particularly those in labour intensive sectors, will need to be well prepared to avoid being caught out by last minute price chips.
Cash on sale
Sellers should also bear in mind that it is not only the NICs increases that may impact a business sale; the 1.25 per cent increase in dividend tax rates from 6 April 2022 may affect them as well. If there is surplus cash in the business at the point of sale, it is generally more tax efficient for the value of the excess cash to be included in the sale, so that the sellers benefit from capital tax treatment. However, this can result in cash flow issues for the buyer, and they often expect cash to be stripped out (by way of dividend) ahead of the sale. Whilst this is a point for negotiation, and clearly depends on the levels of surplus cash in the business, we tend to see sellers having to pay the already higher dividend tax rates in around 10 per cent to 20 per cent of cases. This is a point for sellers to raise early on in the sale process to avoid any costly misunderstandings later on in the transaction.
Selling a business is often a once in a lifetime event and can be an emotional time for many business owners. Taking specialist advice on the detailed tax implications can make the journey a little smoother and help to protect the value that has been worked so hard for.